Consumption Tax

[An updated version of this article can be found at Consumption Tax in the 2nd edition.]

For most of the twentieth century, the principal federal tax on individuals in the United States was on income, whether it is earned from labor (wages and salaries) or capital (interest, dividends, and capital gains). But a growing number of economists and politicians have concluded that the United States should replace the income tax—partially or entirely—with a tax on consumption.

Most of the political debate over a consumption tax has centered on whether the United States should adopt a value-added tax (VAT) similar to the ones that European countries have. While a VAT definitely is a tax on consumption, it is not the kind that most consumption-tax advocates prefer. What's more, the debate over whether to add a VAT to the U.S. tax code has obscured the more basic issue of whether to tax income or consumption.

A consumption tax—also known as an expenditures tax, consumed-income tax, or cash-flow tax—is a tax on what people spend instead of what they earn. A VAT does that in the same way that a sales tax does. But a true consumption-tax system would entail something much different from simply layering a VAT on top of the current income tax. One way to think of a consumption-tax system is simply as an income tax that allows unlimited deductions for savings and that taxes all withdrawals from savings, much like independent retirement accounts (IRAs).

Proponents of a consumption tax argue that it is superior to an income tax because it achieves what tax economists call "temporal neutrality." A tax is "neutral" if it does not alter spending habits or behavior patterns and thus does not distort the allocation of resources. No tax is completely neutral, since taxing any activity will cause people to do less of it and more of other things. For instance, the income tax creates a "tax wedge" between the value of a person's labor (what employers are willing to pay) and what the person receives (after-tax income). As a result, people work less (and choose more leisure) than they would in a world with no taxes.

The theoretical case for a consumption tax actually is a case against the income tax. Champions of a consumption tax argue that the income tax does enormous long-term damage to the economy because it penalizes thrift by taxing away part of the return to saving. This tax wedge results in less saving, less investment, less innovation, and lower living standards than we would enjoy without a tax on saving. In other words, the income tax creates a bias in favor of current consumption at the expense of saving and future consumption.

Equally important, the result is less saving than society would choose in the absence of any taxes. The "social value" of saving is the market interest rate that borrowers are willing to pay for the use of resources now. (Economists are confident this is the value to society because it is the price society has established by bidding for savings, or offering savings to borrowers, in the marketplace.) If each potential saver could collect that market interest rate, the result would be an optimal amount of saving (that is, an optimal division of resources between present and future consumption). Optimal in this sense refers to the amount of saving that individuals, deciding freely on the basis of market prices, would choose to do on their own, rather than the amount of saving that a politician, social planner, or economist thinks they ought to do. But the income tax creates a wedge: the after-tax interest that savers receive is less than the pretax market interest that borrowers pay. So we get less than the optimal amount of saving.

In contrast, a properly constructed consumption tax can be neutral between consumption and saving. That is because taxes fall only on income that is consumed, not on income that is saved. The results are that the tax wedge on saving is zero and that total saving in the economy is much closer to the optimal amount.

To see how this works, first consider what happens with the income tax to a person with $10,000 of pretax income. Assume for simplicity that the only tax bracket is 25 percent, that the market (pretax) interest rate on bonds is 5 percent, and that inflation is zero. Under the income tax, the individual pays $2,500 in taxes no matter what he does, and then can consume $7,500 of goods and services now. Or he can save $7,500, investing it in bonds paying 5 percent interest. In the first year the individual earns $375 interest (5 percent of $7,500), pays 25 percent of that ($93.75) in taxes, and is left with $281.25 of after-tax interest income. Added to his original $7,500, he now can consume $7,781.25 of goods and services, or 3.75 percent more than a year ago. Note that the market paid the individual 5 percent to postpone consumption. But the income tax reduced what he received to 3.75 percent.

Now look at what happens under a consumption tax. If the individual consumes all his income, he pays the same $2,500 in taxes and has the same $7,500 to spend on goods and services. But if he saves all his income, he can invest $10,000 because he gets a deduction for all income saved. In the first year he earns $500 interest (5 percent of $10,000), leaving him with $10,500. If he wants to spend all of that now, he must pay taxes equal to 25 percent of the full $10,500, or $2,625. That is because all withdrawals from savings are taxable. After paying his taxes, the individual can consume $7,875 of goods and services. That is 5 percent more than the $7,500 he could have consumed a year earlier. The individual receives the full 5 percent market interest rate, and there is no tax distortion between present and future consumption.

Despite its allure of eliminating the current tax bias against saving, a true consumption tax runs into fervent opposition from some (mostly liberal) economists. The one objection to a consumption tax that is based on pure economics is that it would require a higher tax rate in order to raise the same revenue as the income tax. That is because saved income is gone from the tax base. For this reason a consumption tax would be less neutral between work and leisure than an income tax. Advocates of a consumption tax maintain that the gains from additional saving and investment would outweigh the losses from less work effort. It is, however, impossible to know with certainty whether that is correct.

The practical objection to a consumption tax used to be that it is too complicated to monitor the amounts that people save or dissave each year. But that actually can be done quite easily, as we have learned with more than a decade of experience with IRAs. Moving to a complete consumption-tax system for the individual tax code would entail little more than allowing universal, unlimited IRAs and doing away with penalties for early withdrawals. That is, everyone would be able to contribute any amount he or she liked to an IRA or similar saving account and deduct the contribution from taxable income. Investment income would accumulate tax-free in the account, but all withdrawals, including principal, would be added to taxable income. People would not have to pay a penalty if they withdrew funds before waiting until age fifty-nine and a half, as they do now.

Another objection to a consumption tax is that it would be regressive (i.e., it would fall most heavily on those with the lowest incomes). The fear is that the tax burden would be shifted to labor because returns to saving and investments—which constitute a much larger share of income in the upper brackets—would not be taxed. That is partly true. IRAs, for example, have precisely the effect of making returns to saving tax-free. The objection, however, ignores two facts: income from existing capital would be tax exempt only if it was saved, and labor income that was saved would get the same exemption.

A similar objection is that people higher up the income spectrum save a larger portion of their incomes, and so would get a disproportionate share of the benefits from deducting IRA contributions. Advocates of a consumption tax respond with the argument that the middle class would have more parity with the wealthy than under the current system. As it stands now, people with substantial assets can let unrealized capital gains accrue untaxed (see Capital Gains Taxes), while wages and savings-account interest are taxed immediately.

Some supporters of a consumption tax actually see it as more equitable than the income tax. William Andrews, a Harvard law professor, makes the argument that taxing income—whether from labor or capital—taxes people on the basis of what they contribute to society. Taxing consumption, he argues, taxes what they take out.

IRAs were extremely popular during the eighties, when anyone could make deductible contributions to them of up to two thousand dollars a year. As attention has focused on the need for more saving and capital formation in the United States, bipartisan support for restoration of universal IRAs has been building in Congress. In addition, former President Bush and others have endorsed the idea of other special IRA-like savings accounts for such things as buying a first home and financing a college education. While a full consumption-tax system seems unlikely, there is a good chance that Congress will liberalize IRA rules again in the nineties.

About the Author

Al Ehrbar is a partner of Stern, Stewart and president of EVA Institute. He has been a senior editor of Fortune magazine and editor of Corporate Finance magazine.

The cuneiform inscription in the Liberty Fund logo is the earliest-known written appearance of the word "freedom" (amagi), or "liberty." It is taken from a clay document written about 2300 B.C. in the Sumerian city-state of Lagash.